Chapter 5 - Avoid Mutual Funds…Embrace Exchange-Traded Funds

“Rely on the ordinary virtues that intelligent, balanced human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance.”  – John Bogle, American investor and pioneer of low-cost index investing

I invite you to revisit the Mutual Funds and Exchange-Traded Funds sections of Chapter 3 – Investment Types to refresh your memory on how these funds work. 

What you don’t know about the Mutual Fund Industry

“Wall Street people learn nothing and forget everything.”  – Benjamin Graham, famous American investor

There are currently more mutual funds in existence in North America than there are stocks.  The industry is estimated to be worth upwards of $8 trillion.  In Canada, the mutual fund industry is said to be worth around 610 billion dollars (2006 estimate).  This represents over half of the country’s GDP.  It’s a huge market!  Moreover, Canada has the highest mutual fund related fees in the world.  In the United States the industry represents over fifty-five percent of its GDP.  Again, this is huge.  And as we all know, big industries go to great lengths to preserve their wealth and power (just look at the oil and tobacco industries).  Consequently, the mutual fund industry will pull out all the stops, usually at the investor’s expense, to remain very profitable.  It is a well-known fact that mutual fund managers act more as salespeople than anything else.  The mutual fund industry is a well-oiled marketing machine.  It is actually more a model of marketing success than an investment success.  They are obsessed with sales and, as a result, their managers are compensated according to their ability to sell funds rather than effectively manage them.  A significant part of their salaries is linked to their capacity to attract herds of investors to their funds.  A study by an American firm – Greenwich Associates– reveals this.  In 1999, the average salary for Canadian fund managers was $312,000.  And in 2003, despite the stock market tumble that had occurred between 2000 and 2002, the average salary actually rose to $426,000. 

Various research and sources (including Standard & Poors) indicate that roughly 80% of mutual funds don’t beat the average return of the stock market.  Think about this for a second.  This means that only about 20% of mutual fund stock pickers (i.e., professional investment managers) are able to pick stocks that beat the overall market.  In other words, and mathematically speaking, you have only a one in five chance that your mutual fund will have any success worth mentioning.  As a whole, and for as long as they have been around, actively-managed mutual funds have underperformed against the major market indices by 2% to 3% per year.  Therefore you would be better off simply buying a passively-managed index fund or ETF that tracks a broad market index; it would generate a higher return with much lower fees.  The reason why actively-managed mutual funds do so poorly is due in large part to the reshuffling of stocks within the fund’s portfolio.  This reshuffling is referred to as Portfolio Turnover.  It means that the fund’s manager sells some of the stocks in the portfolio and buys others.  Although the intent may be good, this strategy carries two negative consequences.  First, it increases trading costs which you will ultimately end up paying.  And second, it defeats the purpose of accumulating wealth over the long term.  Moreover, the manager focuses on short-term profits by attempting to predict or time the market.  Market Timing is a strategy that has been used by traders ever since stocks have been traded.  With this strategy a trader simply buys a very large quantity of a given stock, holds it for a short while, and then sells it at a profit after the slightest upward shift in price.  A trader may trade the same stock many times over the course of one year.  This turnover phenomenon is not just happening in a fund’s portfolio; it is occurring across the entire stock market.  About 80% of trades enacted on stock markets are placed by institutional investors like mutual fund companies.  They all try to outperform each other.  But, you see, the stock market is a zero-sum game.  While some will get above average returns, others will not.  They can’t all beat the market!  Since they all constantly keep buying and selling stocks for the short term, it has a negative consequence on those who wish to really invest in a company by faithfully holding on to its stock for the long term.  And that is really what the original idea of a mutual fund (or stock) is all about – creating wealth over the long term for its investors.  If you ask me, these actions by the mutual fund companies and managers represent a conflict of interest, since it is the unitholders who really pay the price.  And the mutual fund companies will always collect the charges from their unitholders whether the fund makes money or not.  It’s just a big waste of time and money.

Another thing you should know about the industry is that mutual fund companies can merge a badly performing fund with a better performing one.  And they will often spend large amounts of cash to advertise its best performing funds.  The result can be misleading or even deceiving to new investors.

Another key difference between mutual funds and exchange-traded funds is that it is not always clear to unitholders which securities are held in the fund.  A fund’s holdings may frequently change due to frequent reshuffling.  The fund’s manager is under no obligation to disclose the holdings on a daily basis to unitholders.  With ETFs, the holdings are almost always the same as they are comprised of the same securities that make up the index they track.  But with mutual funds it may take a few months before the positions are disclosed to unitholders. 

On average, fees or expenses have increased over the last several years as well.  In other words, mutual funds are becoming more expensive.  This is not surprising, as more cash is needed to fuel increases in portfolio turnover.

It’s the fees that kill you!

It’s the fees and expenses that are the real killers for mutual fund investors.  Besides the sales charges or loads (see Chapter 3 – Investment Types – Mutual Funds), mutual fund owners are charged annual management fees or MERs that can vary from a little over 1% to as much as 5% for actively-managed funds, or under 1% for passively-managed funds such as index funds.  A ball-park average MER fee for the average mutual fund lies between 1.5% and 2%.  To be more precise, in a 2006 study entitled Mutual Fund Fees Around the World, British and American researchers observed, after comparing more than 46,000 mutual funds from around the world, that the average fee in the U.S. was 1.42% while Canada’s was almost double at 2.68%.  An earlier study from Morningstar reveals the average fee for Canadian funds at 2.44%.  But what is usually not stated or disclosed to investors are the additional costs related to portfolio turnover, capital gains taxes on the sale of holdings, and opportunity costs of the cash that is set aside for transaction costs.  Add all these fees together and you can easily tack on another 1.5%.  This means that it is not uncommon to see the true expense or fees for the average mutual fund reach 3% (excluding sales charges or loads).  Management fees or MERs for exchange-traded funds lie in the 0.1% to 0.65% range although most of them are under 0.5%.  A 1% or 2% MER difference between a mutual fund and an ETF may not seem like much but over the long term it can have a huge impact on your returns.  Let’s demonstrate with an example.  Suppose you use $10,000 to purchase a U.S. equity mutual fund that tracks the index of the overall U.S. market such as the S&P 500, and the MER fee for the fund is set at 2% with a 2% initial sales load charge.  Assume that an ETF exists that tracks the same index but only charges 0.5% MER.  Also assume that the index returns about 10% annually.  Over a forty-year period, the return for the mutual fund would be $197,686 as opposed to $370,366 for the ETF.  Do you see the difference the percentage point plus the sales load makes?  This represents approximately a 46.6% reduction on your return.  Ouch.    

There are a few excellent mutual fund fee and expense calculators available on the Web (see link box further below).  The SEC Mutual Fund Cost Calculator lets you enter the dollar amount invested, the expected annual rate of return, the total annual operating expenses (MER), and the holding period (in years); it will then compute the total fees and foregone earnings for you.  This is much easier than trying to calculate this by hand on your own.  The foregone earnings represent the amount of money which could have been invested if there had been no sales charges and fees.  This is the calculator I used for the example described above.  I strongly encourage you to try it out with different variables, as the results will astound you.  The second calculator on the list is the FINRA Mutual Fund Expense Analyzer.  I really like this one because, like the previous one, it is created by a very reputable organization – FINRA.  FINRA, or Financial Industry Regulatory Authority (formerly the National Association of Securities Dealers or NASD).  It is a regulatory agency that overseas the activities of more than 5,000 brokerage firms and over half a million registered securities representatives in the United States.  It oversees and regulates the trading of stocks, corporate bonds, as well as other securities.  It represents the interests of investors.  So you can definitely count on it.  What sets this site apart is that it allows you to compare the expenses of up to three mutual funds and ETFs at the same time.  You simply need to select existing mutual funds or ETFs from a pull-down list.  Thousands of funds from hundreds of different mutual fund companies as well as ETF providers are available for selection.  Chances are that the fund or ETF that may interest you is included in their list.  However, Canadian mutual fund companies don’t appear to be included in their database.  All you need to do is select the funds, enter the initial investment amount, the expected rate of return, and the holding period (in years), and the analyzer will provide you with a detailed report about the fund’s value and expenses over the holding period.  It will even include a year by year statement of related returns and fees.  You do not need to enter the sales charges or load information, as they are already included in their database.  The results page also provides this information for you.  In addition, the report will include actual Average Annual Returns for prior one-year, five-years, ten-years, and “Since Inception” periods that the funds have generated in the past.  This is a useful feature as it lets you compare the past performance of funds as well.  I actually tried out the analyzer to compare the returns and expenses of the following (similar) funds for a $10,000 investment over a twenty year period (assuming a 13% return):

1. Mutual Fund: Goldman Sachs Concentrated Emerging Markets Equity Fund Class A (ticker: GSAEX)
2. ETF: iShares MSCI Emerging Markets Index Fund (ticker: EEM)

Total fees and sales charges for the mutual fund amounted to $12,620 while they were $5,811 for the ETF, representing over a 50% reduction or a $6,809 difference.  Keep in mind that this was only for a period of twenty years (the calculator does not permit calculations for longer periods); but over longer periods, the difference becomes much greater as seen in the previous example.

I strongly encourage you to try it out and experiment with different mutual funds and ETFs.  It is a real gem of a tool because it really shows you the true impact of fees over the long term.  

For Canadians, be sure to try out InvestorEd.ca’s Mutual Fund Fee Impact Calculator.

Tax inefficiencies of mutual funds

Tax implications of mutual funds and ETFs are extremely complex.  Therefore, I will only give you a very brief summary as to why mutual funds are less beneficial from a tax perspective than ETFs.  In essence, actively-managed mutual funds are not tax-efficient because of their high ratios of portfolio turnover.  When many stocks are bought and sold from the fund, it creates realized capital gains.  In other words, each time stocks are sold at a profit it creates a realized capital gain that becomes taxable and for which someone must pay.  That someone is you, even if you are not selling your units of the mutual fund just yet.  In contrast, ETF holders will only need to pay capital gains taxes once, upon the sale of the ETF.  So mutual funds holders are penalized because the taxes they have to assume could have been used to generate additional wealth.  This is another reason why, even with hefty fees and expenses, ETFs outperform mutual funds over the long term.

Buy the stock of the mutual fund companies instead!

At the beginning of this chapter, I mentioned that there are more mutual funds than stocks in North America and that the mutual fund industry represents an $8 trillion industry.  That means that mutual fund companies are collecting torrents of cash through management fees and sales charges.  Each and every year they collect these fees and charges, regardless of the performance of the mutual funds.  Therefore, they have a lot of cash on hand.  Many large mutual fund providers are publicly traded both in Canada and the United States.  And many of these publicly-traded companies issue dividends to their stockholders.  It is almost ironic to realize that the stocks of the mutual fund providers usually outperform the actual funds they manage.  All you need to do to verify this is to go on the Internet and compare the performance of the mutual fund company’s stock and its funds.  However, this is becoming more difficult to do each year, as mutual fund companies are providing fewer data about the performance of their funds on their websites.  Do they have something to hide?  Nevertheless, do try to see (in general) if you can compare the performance of their mutual funds versus their stock (on a one-Year, five-Year, ten-Year, and “Since-Inception” basis).  To check the performance of their stocks, I recommend using the “Interactive Chart” feature from BigCharts.com as you can easily get (daily) prices of stocks dating back ten years.  If you can determine that their mutual funds are providing a much smaller return, then you are better off buying the stock of the mutual fund company instead of the funds it sells.  Recall that only 20% of actively-managed funds beat the market.  Therefore, by buying the stock instead you are increasing your chances of success.  Plus, you may even collect dividends in the process that are more tax-efficient, helping you accumulate even more wealth.  There is an option in BigCharts.com that can be used to display if, when, and how much dividends are distributed.

Side-by-Side: mutual funds versus ETFs

In this section I will summarize the key differences between actively-managed mutual funds, passively-managed mutual funds, and ETFs.  As for passively-managed mutual funds such as index funds, I want to point out that they carry some advantages that are similar to those in ETFs. 

Table 15 – Key differences between Mutual Funds and ETFs

As you can see from the table, above ETFs carry many significant advantages over actively-managed mutual funds.

To learn more about the pitfalls of mutual funds and the mutual fund industry, I recommend the following three books:

1. Stop Buying Mutual Funds – Easy Ways to Beat the Pros Investing on Your Own by Mark J. Heinzl
2. Stop Wasting Your Wealth in Mutual Funds: Separately Managed Accounts – The Smart Alternative by Don Wilkinson
3. The Great Mutual Fund Trap: An Investment Recovery Plan by Gregory Arthur Baer and Gary Gensler

The first book takes a long hard look at (among other things) Canadian Equity mutual funds and provides actual performance data for both Canadian and U.S. fund companies.  The author – Mark J. Heinzl – has written articles for The Wall Street Journal, the Dow Jones Newswires in Toronto, as well as the Globe and Mail (Canadian daily newspaper).  The second book is similar in nature to the first one and is written by a financial expert – Don Wilkinson – who is a former mutual fund sales manager for thirty years.  The third book was written by two former U.S. Treasury officials.  Their former duties included regulation of financial-services firms.  Therefore, they have the inside scoop on the practices of mutual fund companies.  They have conducted exhaustive research on the subject and provide hair-raising findings in the first half of their book.  I encourage you to consult these works to get a more in-depth analysis of the subjects we explored in this chapter.

© Dan Fournier, 2007-2011